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More Car Trouble

U.S. automakers are heading for another bump.

The Big Three automakers have had an impressive recovery. After a near-death experience in 2007-09, the U.S. automotive industry has come back with a vengeance, proving yet again that those who write off America do so at their own risk. Last year, General Motors sold 9.2 million vehicles worldwide, posting a 3% gain. GM is locked in a three-way race with Toyota and Volkswagen for the No. 1 spot among volume automakers. Ford sales were strong as well, topping 2 million units in the U.S. alone, and Chrysler was the best performer, albeit increasing sales from a low base. Still, its Jeep brand sold a record 700,000 vehicles worldwide.

Financial results have been equally impressive. Ford’s pretax profits in 2012 were the highest in more than ten years, reaching $8 billion. The company not only resumed regular dividends in early 2012, but doubled them a year later. GM is running close to Ford in terms of profits, and, while the company projects only a modest improvement in 2013, some analysts believe that its profitability could be boosted substantially this year.

Chrysler—which seemed like a gamble when Fiat took it over in 2009—earned a $1.5 billion net profit last year and has an $11 billion cash pile.

Better Companies

Financial performance was helped by a strong recovery in the U.S. market last year, where sales jumped 13.4%, with nearly 14.5 million cars and light trucks sold. Strong sales continued into early 2013. But this is only a small part of the story. The Big Three are now far more efficient, better managed companies. They have been able to overcome the resistance of the trade unions to more flexible work rules and more competitive wages.

Bankruptcy allowed GM and Chrysler to shed onerous unfunded liabilities to retired employees. As a result, the cost advantage in favor of Japanese manufacturers, measuring $1,000-2,000 per vehicles, has swung into the opposite direction.

The Big Three prospered last year by selling American drivers smaller, more energy efficient cars, but this merely indicated that they have become more responsive to the need of the markets. Chrysler executives believe that demand for pickup trucks and SUVs will rise this year, reflecting a return to normal market conditions and rebound in residential construction. If this happens, U.S. companies will not be caught with showrooms full of subcompacts, but adjust their offerings accordingly.

Moreover, Detroit is now a global city. GM remains the top seller in China, the world’s largest motor vehicles market, just ahead of arch-rival Volkswagen. Ford is number two in Europe, and it posted gains in sales all over the world last year. Even Chrysler, which heavily relies on the U.S. market, has increased its global reach sharply, thanks to the international network of Fiat dealerships.

And yet automotive stocks have not been high fliers. Chrysler shares are not traded, and GM and Ford have performed poorly. To be sure, shares are up since mid-2012. GM shares have gained around 50%, reaching their highest level in nearly two years in early 2013. Ford shares similarly reached a two-year high in January. But their shares remain remarkably cheap. Ford, while paying a 3% annual dividend (compared to the average yield of around 2% for S&P 500 shares) trades at a price-to-earnings multiple of under 9. GM’s P/E is not much higher, or around 11. This is still well below the average of nearly 17 for S&P 500 stocks.

Sales in Europe continue to flag after posting their worst result in 19 years in 2012, but sales growth was never expected to come from Europe, anyway. Instead, U.S. automakers have bolstered their positions in emerging markets, where the action has now shifted. India and other parts of Asia outside China, Latin America and Russia will continue to boost global demand for cars. After worldwide sales hit a record 80 million vehicles last year, a study by IHS Automotive predicted a rise to 100 million in five years, fueled by emerging markets.

This year, the automotive market will likely post another sales record, with an average forecast calling for a 4% rise in sales. Stock analysts are bullish on Ford and GM, giving both a “buy” rating and expecting solid price gains in 2013 even after a strong rally in the second half of 2012 and into 2013. Surely, their P/Es have room for improvement. Chrysler’s Italian parent, after raising its controlling stake in the company from 58.5% to 61.8% in mid-2012, is rumored to be readying it for an IPO in late 2013, also thanks to its strengthening balance sheet.

But optimism about the U.S. auto industry may be overdone. The problem lies not with the Detroit automakers or their management, but with the structure of the global auto industry—or, more precisely, with its mass market segment.

While upscale producers, especially German worldwide brands BMW, Daimler, Audi and Porsche along with U.K.’s Land Rover and Jaguar, are doing remarkably well, increasing both sales and profits, the middle section of the market is mired in stagnation. A survey by KPMG found in early 2013 that 29% of high-level auto industry executives believe that the industry is suffering from at least 21% overcapacity. Nevertheless, 64% of those same executives surveyed are planning to increase investment in plants over the next five years.

Political Problems

The reason why overcapacity plagues the auto industry is seen in the plight of GM and Chrysler. In 2008-09, the Bush and Obama administrations plowed a total of $85 billion into the domestic auto industry to ensure its survival. Both companies were saved, while more than a million American jobs were preserved and another 167,000 will be created by 2015. And, even if the government suffers losses, the overall cost of the bailout to the taxpayer will not exceed $25 billion. As far as public job-creation schemes go, this seems to be the money well spent.

But it was probably a long-term disaster for the auto industry. U.S. government funds were used to perpetuate overcapacity in the global industry, and Washington set a dangerous precedent for others to follow. Automakers in France and Italy were also bailed out with government loans in 2008, and in the current euro-zone recession, attempts by Fiat, Renault and Peugeot-Citroen to shut down superfluous plants are being doggedly resisted by politicians. National governments are prepared to spend public funds to save domestic jobs even if it means further undermining free market forces in the automotive industry.

Meanwhile, the Chinese government is fostering its national auto industry, as well. While the proprietary brands of companies such as SAIC, Dongfeng, Chery and others are virtually unknown in the West, they are starting to gain market shares in smaller, poorer countries where their low price trumps their low quality in the eyes of local drivers. In India, as well, local companies are revving up production of their proprietary brands. Indian producers such as Tata and Maruti are starting to export their vehicles to parts of Asia, Africa and the Middle East.

Given these dynamics of the automotive industry, competition in the mass market segment will continue to intensify. Faced with poor sales at home, global automakers will keep pushing into new markets, where sales are picking up. Russia, for example, saw its car sales escalate in 2012, touching the 3 million mark. Russia is now as big a market as Germany in terms of volume. Foreign automakers have been investing heavily into plants in Russia, with Nissan, Ford, Fiat and Renault all opening new facilities or upgrading existing ones.

While demand for affordably priced vehicles will continue to increase in international markets, global capacity will remain underutilized, and new investment will perpetuate the global glut. As a result, successes by any volume automaker, no matter how efficient, cost-conscious and technologically advanced, will be temporary.

Just as the Detroit Big Three were in trouble in 2008, so a number of European carmakers are now teetering on the brink of collapse. They will not be allowed to go belly-up by their governments, and in a few years the situation may be reversed once more. Persistently low P/E ratios of Ford and GM reflect investors’ misgivings that their current success could last.

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